Wednesday, April 11, 2007

The Difference Between Risk and Fear

Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or give way to hope, fear and greed. Benjamin Graham

In personal finance it is important to know the difference risk and fear. Understanding risk allows one to take prudent chances to build wealth. Allowing fear (or lack of fear) to take over can prevent one from taking reasonable risks (or cause one to take unreasonable risks).

Let me illustrate the difference between fear and risk with a few examples.

Definition of Risk

Suppose we are playing a game based on a coin flip. Heads you win, tails you lose. The prize is one dollar. You are required to play 10 times. How much should one pay to play the game to maintain "zero" risk? The answer is 50 cents. Over the long term, one would break even since the probability is 50/50.

Why? First, this example is not a bet - i.e. where one gets their wager back with their winnings. In this example, one pays to play, which is forever spent, and the winnings are the only return. Thus, when one pays 50 cents and wins, the net winnings are 50 cents. Second, the statistical expected value in this game in 50 cents, because a coin flip has a 50% probability of a head or tail and the payout is one dollar.

For me, risk is an estimate of the payout probability versus the cost to play.

Low risk. Long term payout greater than cost. There may be short term losses. In this example, it would be paying less than 50 cents to play.

Risk neutral. Long term payout equal to cost - i.e. no gain or loss. This is paying 50 cents to play.

High risk. Long term payout less than cost. In the short term, one may win. This is paying over 50 cents to play.

Definition of Fear

So what is fear? Using the same situation as above, here are some questions to answer that will help define fear:

If the prize was $1, would you pay 25 cents to play?
If the prize was $100, would you pay $25 to play?
If the prize was $1,000, would you pay $250 to play?
If the prize was $10,000, would you pay $$2,500 to play?
If the prize was $100,000, would you pay $25,000 to play?

Statistically, the answer should be yes. These all have returns greater than risk and one should take all these "investments." One is guaranteed to win in the long term since the payout probability is better than the cost of playing.

However, most people stop playing at one of the higher values. Why? Because the fear of losing the higher cost to play becomes a bigger factor at higher prize values. It may be acceptable to lose $25, but not $25,000. And while the prize payout is in one's favor, each play is not a guaranteed win. So the fear of losing once, twice or more begins to be the determining factor.

Risk and Fear with Respect to Investing
The confusion between risk and fear can become evident when people are investing. Fear or the lack of fear often causes one to make the wrong investment decision.

For example, since 1926 the stock market has averaged 10% returns. From a risk perspective, one should be invested in the stock market. Very few alternative investments have a comparable return. The long term results favor the person invested in the market. However, I know people who will not invest in stocks either due to the 2002 bear market results, or thinking the stock market is akin to gambling. Because the perceived short term losses are high, fear is causing these people not to take a good risk opportunity.

On the other hand, penny stocks are attractive to many investors. From a risk perspective, penny stocks are high risk versus the possible return, i.e. unlikely to return a gain. However, many people still invest in penny stocks because they only "invest what they are willing to lose." Here, the lack of fear causes people to invest in these poor risk options.

My Situation
I wanted to tell my readers that I base my investment decisions on risk:-) However, in thinking about my own situation, I may be letting fear affect my investment decisions. I am over weighted in CDs and Bonds, which are "risk neutral." I am under invested in the overall stock market, which has good returns and is low risk in the long term. I am also over weighted in investing in my company's stock, which has a possibility of high gains but with higher risk.

Fortunately for me, my company stock has had higher returns than the stock market index over the long term. However, based on this analysis, I should invest more in the stock market index and less in CDs and bonds. In addition, I should start reducing the holdings in my company's stock. I will begin making these asset allocation adjustments in the next few months.

For more on The Practice of Personal Finance , check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

1 comment:

living off dividends said...

i would say that investing in CD/Bonds are not risk neutral.

you're losing more to inflation than you're getting.

that being said, I have 50% of my liquid networth tied up in just cash earning less than 1%. geez, i'm such a hypocrite!